Financing and monitoring in an emerging economy: Can investment efficiency be increased?

- Chinese financial system is unique in nature.
- Financial system is crucial in economy to enhance firms' investments efficiency due to monitoring and financing ability.
- Development in financial system can eliminate the problems of financing constraints and agency problem in Chinese firms.
- Capital market based financial structure suits best to Chinese economy.

This study investigates the influence of the financial system on firms' investment efficiency in China. For this purpose, we employ country level data of capital markets and financial institutions along with financial data from 2797 Chinese firms in the period from 1998 to 2015. The firms are priori classified into four groups, by high and low values of financial constraints and agency problems. Results show that financial development influences firms' investments positively either directly or by reducing cash flow sensitivity. The impact remains the same for all types of firms. Moreover, the financial structure has an impact on investment efficiency of firms; this result also remains the same even after controlling levels of financial development. Study contributes that capital market based financial structure impacts investment decisions by reducing financing constraints and agency issue due to its strong monitoring ability.